The Essentials of Annuity Taxation

Annuity taxation is fairly straightforward at first glance. Taxes are deferred on annuity income as long as it remains in the plan. Eventually, however, monies in an annuity plan are taxed, so when, exactly, does annuity taxation occur?

Deferred Annuities:

Deferred annuities have an accumulation phase and a distribution phase. Earnings grow on a tax-free basis throughout the years of the accumulation phase. In the distribution phase, payouts from these funds are made, either as a series of regular payments over a specific period of time or as a one-time, lump sum payment. Regardless of the form of the payout, some income taxes will be imposed on every annuity payment the owner of the plan (the annuitant) receives from it.

Lump sum payments incur income taxes on the difference between the amount that has been paid into the plan and the value at the time it is paid out, or distributed. If you take your distributions as a series of regular payments, part of each payment is viewed as a return of your previously taxed investment, and part is treated as earnings. Income taxes are owed on the earnings portion. The portion that is not subject to taxation is determined via an exclusion ratio (your investment amount divided by the total amount you expect to get during the distribution period).

Taxation of a Lump Sum Distribution:

If you invested $200,000 in an annuity, and it grows to $450,000 by the time you retire, and you take that total as a lump sum distribution, you owe taxes on the $250,000 your annuity has earned since your initial investment. This is taxed as ordinary income determined by the tax rates in effect when you take the payment. No capital gains tax break is available in this case.

Taxation of Periodic Annuity Payouts:

If you invest $100,000 in a fixed annuity that pays $750 each month for your lifetime, beginning at age 62, you will receive the payments for 22.5 years, according to the life expectancy tables used by the Internal Revenue Service. This means your annuity contract is valued at $202,500. The exclusion ratio is 49.4 percent, so you can exclude $4,446 of the $9,000 total you’d receive over a year from your income. Ordinary income taxes are imposed on the remaining amount.

Taxation of Variable Annuities:

Taxation of variable annuities takes into account the fact that you do not know how much an annuity payment will be every month because the value of your investment will change as the market changes. In this case, exclusions are determine by dividing the investment by the period of time you expect to receive the annuity.

For more information from Steven on how to invest in annuities, their pros & cons, and common investment mistakes, visit his Annuities Investment Guide.